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FRM Part I · FRM Exam Part I · Central Clearing

Bank A and Bank B agree an OTC interest rate swap that is later submitted to a central counterparty (CCP) for clearing. After the CCP accepts the trade, which description of the legal relationships is correct?

Novation replaces the original bilateral contract with two new contracts, one between each original party and the CCP. The CCP becomes buyer to the seller and seller to the buyer, so the original parties no longer face each other. A mere guarantee would leave the bilateral contract in place.

  1. ABank A and Bank B keep their original contract, and the CCP guarantees it only if one party defaults
  2. BThe original contract is replaced by two contracts: Bank A faces the CCP as counterparty and Bank B faces the CCP as counterpartyCorrect
  3. CThe CCP becomes a third party to the original contract, so the three parties share the obligations jointly
  4. DThe CCP takes the trade onto its own books for one day and then returns it to the two banks

Explanation

Through novation, the CCP becomes the buyer to every seller and the seller to every buyer. The original bilateral contract is extinguished and replaced by two contracts with the CCP. The first option describes a guarantee, not novation, and leaves the bilateral exposure in place.

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